This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

26 August 2009

U.S. Industrial Policy: “Cash for Clunkers” and Cap & Trade

Introduction: What “Industrial Policy” Is. Not for nothing did President Obama work as a professor for ten years. He knows how to teach us things we’ve had trouble understanding for decades.

The President’s latest feat is explaining the meaning and value of “industrial policy” without ever using the term. For that’s precisely what “Cash for Clunkers” is.

“Industrial policy” is the use of governmental power and influence in the service of specific (often neglected) goals that promote the general welfare, usually in the long term. Industrial policy works best—and is most needed—when markets fail to achieve (or sometimes even to address) important societal goals.

As you may have noticed, private markets haven’t done these jobs, despite decades of paeans to their puissance.

Every other nation has some form of industrial policy. We did, too, during our most successful years, until Ronald Reagan gave us the notion that government is incompetent and private entrepreneurs always smarter. To prove that notion, Reagan and his sucessors virtually destroyed our public sphere, and much of our private sphere with it. But now that era is over.

What Industrial Policy Is Not. To many conservatives, the term “industrial policy” conjures up the ghosts of socialism, even Communism. But government control of any industrial sector—let alone the entire economy—is obsolete. No serious policy maker proposes it anymore. If you haven’t noticed, Marx and Engels are long dead. They remain dead although conservatives delight in exhuming their corpses just to shoot them down again.

But industrial policy isn’t government control or anything like it. Saying industrial policy won’t work because Communism failed is a bit like cursing modern medicine because using leeches for bloodletting killed the patient. In the century-plus since Marx and Engels did their lamentable creative writing, economists and policymakers (even in Russia) have become much, much smarter. Comparing modern industrial policy with Communism is about like comparing modern open-heart surgery with leeches.

New economic theory disfavors mandates, even isolated, targeted ones. I have described economic mandates as like trying to fix a broken clock by forcing the hands to show the right time of day. The correct time will soon be incorrect, and the method totally ignores the delicate mechanism that needs fixing. To fix a clock—or an economy—you have to know something about the underlying mechanism and how it works.

That’s where industrial policy is today. Central control is out. Mandates are out. Specific, targeted incentives based on understanding markets are in. Incentives like that are what “Cash for Clunkers” provided and cap-and-trade will provide once adopted.

“Cash for Clunkers.” “Cash for Clunkers” (C for C) is a particularly elegant example for three reasons. First, it’s so simple. Anyone can understand that giving consumers $3,500 to $4,500 to buy a new car is going to motivate purchases that might not otherwise happen. And anyone can understand there is no coercion involved. The extra money is a benefit to consumers; the sales it motivates are voluntary. C for C preserves free markets and free choice.

Second, C for C is elegant because it serves the general welfare in several ways simultaneously. It induces fearful consumers to open their wallets, thereby promoting consumer spending and advancing economic recovery. By inducing consumers to trade inefficient cars in for more efficient ones, it reduces our total demand for oil, decreases our purchases of foreign oil and helps curtail climate change. And by creating a spurt of new sales, it jolts the moribund auto industry into life. That, in turn, leads to increased production and employment in our hard-hit manufacturing sector.

C for C also helps fill the coffers of hard-pressed cities and states. For every car sale it motivates (which otherwise wouldn’t happen), a state or municipality gets a sales or use tax. Let’s say the average price of a C for C car is $15,000, and the average sales/use tax is 6%. Then each sale brings some state and/or its cities some $900. So far, the average C for C incentive is about $4,200. At that rate, $ 3 billion will bring 714,000 new sales, putting $642 million into the coffers of states and cities. As you can see by comparing the incentive with the car price, over three-quarters of that sum will be private money.

Economic growth, energy independence, climate remediation, industrial recovery, increased employment, and relief to states and cities—C for C serves the general welfare in six separate ways. It is a “six-fer.”

Finally, for all that it does, C for C is incredibly cheap. Even with the new tranche of $2 billion, its total projected cost so far is $ 3 billion. That’s not even pocket change today. Here’s how that cost compares to the cost of other government initiatives:

Program

Relative Size of Investment in C for C

Proposed Health Care Fix

0.3 percent

War in Iraq (so far)

0.4 percent

TARP

0.4 percent

Cost of Keeping GM and Chrysler Alive (so far)

4.0 percent

Perspective requires noting that C for C is a small program as government programs go. It is not going to solve any of our major problems all by itself. But it does so much, so well, for so little. And it is so self-evidently effective that it has not only engendered little political opposition; it has met with almost universal approval.

That’s how industrial policy ought to be.

Cap & Trade. Unfortunately, not all industrial policy is so simple to understand. Cap and trade addresses a much more difficult problem than short-term economic stimulus. How can we get polluters to pay for the enormous costs they impose on the rest of us through local and regional air pollution (which ultimately poisons even fish) and climate change?

Those costs are real and growing exponentially. Polluters are treating the air we breathe and our planet’s atmosphere as their personal dumping ground. They pay nothing for the privilege.

Every homeowner who pays for trash removal or the privilege of using a country dump should know that isn’t right. Yet somehow the public hasn’t connected the dots.

Government can’t pay for the massive pollution because the costs are huge. Paying them with taxes would bankrupt us. Anyway, paying with taxes is a bad idea because it would create no incentive for polluters to clean up their acts.

Polluters can’t bear the huge costs of cleanup alone because present market mechanisms don’t include those costs. If we suddenly charge them for dumping into our atmosphere, they will simply raise their prices, and we will have to pay more for coal-based electricity and certain manufactured goods. If we try to prevent them from passing the costs on (for example, through price controls), the polluters will incur massive losses and eventually go bankrupt or require bailouts of their own.

So we have only two choices. We can continue to let polluters use our air and atmosphere as their personal dumping grounds, free of charge. That way we’ll pass on the costs (including respiratory disease, tainted sushi, violent storms, and coastal and island erosion) to our children and grandchildren. Talk about generational theft!

Or we can find a mechanism to let all of us (through taxes or higher prices) pay to reduce pollution and serve the general welfare. We can pay through taxes or higher prices, but someone has to pay. There is no such thing as a free lunch.

Cap and trade provides the best solution that economic thinkers have yet devised. For the first time ever, it puts a market price on pollution. It makes polluters pay to dump their effluent in our air, just as homeowners pay to have their trash hauled away or to use the county dump.

But cap and trade does more, much more. By allowing polluters to trade the dumping rights they buy, it gives everyone incentives to pollute less. Anyone who can figure out a way to do what they do while polluting less can sell their unused dumping rights to more grievous polluters. Major polluters like electric utilities can. But so can everyone in industry—even farmers. All have incentives to cut greenhouse-gas pollution and make money (or save money) by doing so. You can’t get much more sophisticated in understanding markets than that.

I know, I know. The current cap-and-trade bill has far too many exceptions for coal-burning firms—the greatest polluters. But the political power of these polluters (mostly from small states), derives from the Great Compromise that formed our Union. There’s not much we can do about it now but call a new constitutional convention and get the small states to give up their political power voluntarily. Good luck with that!

So on the theory that half a loaf is better than none, we have to accept the monstrosity that Congress has wrought. Over time, the relative effectiveness of cap and trade over alternatives (including taxation and regulation) will become apparent. And as the new market mechanisms begin to put a price on dumping in our air, the economic cost of dumping will become apparent with time. No longer will the public or polluters consider pollution a “right” or costless act.

Our Teacher in Chief has to explain all this, in words that any citizen can understand. Fortunately, he’s extremely good at it.

But there’s one thing about cap and trade that needs much more explaining. In the short term, prices for some things will rise, as polluters begin to pay for dumping in our air that we used to allow for free. The polluters have no choice but to pass the new costs on in their pricing. That’s how markets work.

But that’s only half the story. The whole purpose of cap and trade is to motivate change. It’s not to keep the status quo, whether in pollution or anything else.

Cap and trade will change the status quo in five ways. First, the direct costs it imposes on heavy polluters will motivate their investment in equipment and technology to reduce pollution and hence their costs. Second, light and incidental polluters (like farms whose animals fart methane) can make money by reducing their pollution (for example, by changes in animal diet or husbandry) and selling pollution rights to others. Third, if prices for electricity and other things do rise, consumers will have an incentive to use less. For example, they might turn off lights and heat in unused rooms or buy equipment to do so automatically. Fourth, industrial users will have the same sorts of incentives, which market forces generally cause to act more rapidly on them. Finally, manufacturers will have incentives (and market opportunities) to make equipment that generates electricity more cheaply, avoids pollution in doing so, and allows both residential and industrial users to conserve it without reducing its benefits.

No one can predict how cap and trade’s powerful incentives will change our world. At the turn of the twentieth century, horse shit and the flies it attracted were major annoyances and health hazards in big cities. If someone had proposed capping and trading the “right” to pollute our streets with horse shit, surely someone from the Wall Street Journal’s editorial board would have prophesied higher prices for horse rides and consequent economic collapse. But today horses are virtually gone from our city streets, used only (and rarely) for parades, by mounted police and for tourist photo ops.

The switch from horses to cars occurred without the incentive of a cap and trade program. How much faster will a similar switch from coal occur under powerful incentives to reduce its use? No serious economist can estimate the effect of higher prices without considering the huge changes that cap and trade’s economic incentives are designed to produce. Those changes are not quantifiable, so they can’t and don’t appear in any estimate of short-term cost increases. But how good is an estimate that doesn’t even consider the consequences of a program’s very purpose and modus operandi?

Cap and trade’s incentives certainly will motivate the development of whole new industries. Similar incentives have already produced a massive shift from incandescent to compact fluorescent light bulbs, which are four times more efficient. Including the cost of atmospheric dumping in making electricity from coal will also vastly increase incentives for exploiting wind and solar power, which (unlike coal) have near-zero marginal cost and produce no pollution.

So just like C for C, cap and trade will foster industrial development, new employment, and economic growth. And just as with C for C, the sales of the new energy-producing or energy-saving machines whose development cap and trade will motivate will fill states’ and cities’ coffers with sales and use tax from private sources, without federal subsidies.

Like C for C, cap and trade will even foster energy independence. It will reduce the use of coal—our most abundant fossil fuel—because it is also the most polluting fuel. But by pricing coal power closer to its true cost (including all that atmospheric dumping), it will boost the relative use of wind and solar power, which do not pollute and have near-zero marginal cost.

So cap and trade, like C for C, is a “six-fer” industrial policy. It’s just too bad that its benefits are not as easy to see.

The real marvel is that so-called “conservatives” fail to see them. They’ve spent the last forty years writing odes to the power of the markets. Yet when it comes to cap and trade, all they see is the short-term costs, not the medium-term and long-term changes that cap and trade’s market incentives will produce. This selective blindness to the power of markets requires the talents of our Teacher in Chief.

1 Comments:

I just noticed this, a few months after you posted it. Nice analysis. You're helping to move the debate away from the unproductive argument about "government picking winners" and toward a discussion of how industrial policies fix market failures and promote economic growth along with other social goals. I've been trying to do the same thing in talking about innovation policy; you might be interested in http://www.tnr.com/blog/david-brooks%E2%80%99-innovation-agenda-the-limits-the-market.

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About Me

This blog reflects a quarter century of study and forty years of careers in science/engineering (7 years), law practice (8 years) and law teaching (25 years). A short bio and legal publication list appear here. My pre-retirement 2010 CV appears here.
As I get older, I find myself thinking more like an engineer and less like a lawyer or law professor. Our “advocacy” professions—law, politics, public relations and advertising—train people to take a predetermined position and support it against all opposition. That’s not the best way to make things work—which is what engineers do.
What gets me up in the morning is figuring out how things work and how to make them work better, whether they be vehicles, energy systems, governments or nations.
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